The government last night stunned the City when it banned short-selling of bank shares by speculators, hours after a pledge by Gordon Brown to tackle the deepening global credit crunch with a "clean-up" of the financial markets.

Amid concern that the officially brokered marriage between Lloyds TSB and HBOS could fall victim to the controversial practice of driving down a company's share price, the Financial Services Authority said it was prohibiting the "active creation or increase" of short positions in financial companies for three months, from midnight last night.

In the US, there were similar signs of action as New York's attorney general began a criminal investigation into short-sellers spreading misinformation to drive down banks' stock prices. Last night Wall Street shares delivered the biggest one-day rise for almost six years. The Dow Jones Industrial Average leapt 410 points to 11,019, powered by reports of a US government plan to soak up bad debts from troubled banks. The turnaround provided some respite for Morgan Stanley and Goldman Sachs, the last two remaining investment banks on Wall Street.

Short-selling has inspired government action because ministers are relying on Lloyds TSB's purchase of HBOS to revive the housing market and has agreed to override competition laws in return for a pledge by the newly created megabank to offer more home loans to first-time buyers. The chancellor, Alistair Darling, told the Guardian last night that the events of the past 13 months - culminating in the collapse this week of Lehman Brothers, and the takeover of Merrill Lynch and HBOS - had made the case for improved regulation unanswerable.

Short-selling is where a trader borrows stock and sells it on in the hope of buying it back at a lower price before returning it to the original owner, often large institutional shareholders which charge a fee for the rent of the shares. While Darling is reluctant to ban the practice outright, he is concerned about its impact on the banking sector, where confidence is crucial.

Hector Sants, chief executive of the FSA, said: "While we regard short-selling as a legitimate investment technique in normal market conditions, the current extreme circumstances have given rise to disorderly markets. As a result, we have taken this decisive action, after careful consideration, to protect the fundamental integrity and quality of markets."

Earlier, Brown had sought to take advantage of the government's part in arranging the merger to show that he was committed to reform of the City and tackling the financial crisis. Keen to re-establish his authority ahead of Labour's annual conference, Brown said: "We are cleaning up the financial system where there have been problems and we are going to continue taking whatever action is necessary so we have a stable financial system."

Darling said it was right to waive competition rules to allow the Lloyds TSB merger with HBOS, he said. "If this hadn't gone through, competition would have been an academic problem. HBOS wasn't going to make it through the week."

Last night, the FTSE 100 index fell for the fourth day, despite a $180bn injection to help banks with their cash flow. Lloyds TSB lost 15% as the FTSE closed 32.4 points lower at 4880.0 - a 10% fall this week. Wall Street also sank in early trading but staged a vigorous comeback late in the day, pushed higher by reports that the US government is considering creating a public body to accept banks' bad debts - a move similar to the creation of the Resolution Trust Corporation which tidied up a banking crisis in the early 1990s.

Sir Victor Blank, chairman of Lloyds TSB, yesterday revealed details of the bargain struck with the prime minister to save HBOS. "The transaction could only happen if the government would give its support," he said. "On Monday evening, the prime minister said to me the government would give that support." He was referring to the need for ministers to suspend normal competition policy to allow the deal to take place more rapidly.

When asked how the bank would counter abuse of its market dominance, particularly in mortgages, he said "new lending" by the combined bank for households and small businesses would "continue at least at current levels" and the bank would increase the range of products aimed at first-time buyers.

Amid concern that up to 40,000 of the merged banks' 140,000 jobs could be axed, trade unions said they would not allow any compulsory redundancies. "Staff in financial services should not have to pay the price for the greed and excess of the short-sellers and speculators," said Unite's deputy secretary, Graham Goddard.

City investors supported the FSA move. Guy de Blonay, hedge fund manager at New Star, said: "To bring a sick company to its knees is one thing, but to destroy healthy companies for a quick buck is another."